Dutch Disease and the U.S. Dollar

Includes: DBV, UDN, UUP
by: Mark E. Bachmann, CFA
The announcement that it suddenly appears there may be "nearly $1 trillion" in untapped mineral reserves in Afghanistan caught everyone's attention a couple of weeks ago, at least briefly. In the current economic environment, most of us are becoming a little jaded to the t-word, but in a place like Afghanistan, a trillion US dollars is still real money.
The news report, whether substantive or not, has also brought back into current parlance a term that was coined a few decades ago and has since been bandied about by economists in various contexts.
"Dutch Disease" refers to the paradoxically negative impact that a sudden infusion of wealth, usually from natural resources, can have on an economy unable to put it to work constructively.
The term was originally used to describe what supposedly happened in the Netherlands after large quantities of natural gas were discovered within its territory in the late 1950’s. Dutch Disease has at various times since been blamed for economic dysfunction in Russia, Venezuela, Algeria, Azerbaijan, and other nations where a resource windfall of one sort or another was believed to have actually retarded, rather than stimulated, economic development. Western economists have written disdainfully of the syndrome, the original case aside, as though it were the province of political despots too callous and greedy to know or care about what's truly good for their people.
The theory explaining the Dutch Disease phenomenon is that an economy develops a destructive dependence on any disproportionately valuable and abundant resource. Labor and other input factors gravitate to it and factor costs rise. The nation’s currency appreciates. Consumers seem to enjoy a windfall, but the nation’s productive capacity becomes hollowed out. Manufacturing is driven elsewhere or never develops in the first place, because costs are high and incentives are low. Workers, consumers and business executives become complacent and spoiled. The nation’s political class gains a sense of entitlement.
Does any of this sound familiar?
Alan Greenspan used to talk elliptically, as was his wont, about the benefits of globalization to the U.S. economy. What he was probably getting at was the easy economic power we derive from owning the wellspring of the world's primary reserve currency. We can borrow endlessly without facing prohibitive interest rates, so long as other nations are happy to accumulate our currency. And since they ship us real stuff in return, why pay for the infrastructure to go on making it ourselves? Greenspan talked approvingly of all this, as though he considered the product created by our bankers and politicians to be a sustainable trade for consumer goods from China, or electronics from Japan, or oil from the Middle-East. The Dollar has done for us what gold did for Eighteenth Century Spain, one example that shows how the Dutch Disease phenomenon predated mid-twentieth century Holland. The Dollar, like Spanish gold in the old days, is universal money. It buys everything. For Americans, the dynamic has for a long time seemed too good to be true.
Perhaps we're about to discover the downside.
For Spain, the gold ran out and its empire collapsed. Because the Dollar is a virtual commodity which our banking system creates out of thin air, it can’t run out. What it can do, however, is cease to function as universal money. Then what happens?
Most mainstream economists acknowledge that the dollar reserve regime is an anachronism that at some point will give way to a system more reflective of modern economic relationships. In the same breath, most of those same economists point out, correctly and with some relief, that there is no immediate alternative to the Dollar. They imply that redesign of the international monetary system is but one more intractable problem for the next generation to worry about.
But is it really so remote? And if it does rise up to confront us sooner than we once thought possible, what does the scenario portend?
Nothing good is the first obvious answer, at least from an American perspective. Inflation is the more specific answer.
The Dollar originally achieved its status for a good fundamental reason: it represented purchasing power against the largest and most diverse economy in the world. Enshrined as the cornerstone currency for the Bretton Woods system in 1944, the preeminent Dollar survived the demise of that system and the gold exchange standard around which it was built. As a modern fiat currency, the Dollar became stronger than ever because of America's expanding economic power.
Our capacity for consuming, however, is now growing more rapidly than our capacity for producing. The Dollar's unique role has facilitated this asymmetrical development and fooled us into imagining it to be sustainable.
China and other heavily long-Dollar nations have a legitimate economic incentive seek a stable alternative to the present system for managing payment imbalances. Certain of these nations also have geopolitical motives for challenging American leadership.
Should what everybody now seems to be calling the "fragile global economy" in fact suffer a relapse during the next year, pressures will grow enormously to seek radical solutions to our economic problems. Near the top of the list of such possible changes will be reform of the world's currency reserve system, whether our bankers and economists are up to the task or not.
Should a new regime mean that the US dollar is suddenly in less demand, a tangle of consequences would surely follow. Initially, a weaker currency would offer a welcome respite from deflationary pressures. However, Dutch Disease has taken its toll. We would probably soon learn that our infrastructure today lacks the flexibility it once had to respond to growth opportunities. If such proves to be the case, the stimulus would likely devolve into an inflation that would be beyond the Fed's capacity easily to control.

Investors already have too much to worry about in the current environment, but pending instability in the global monetary system is one issue we neglect at our peril. The crisis may be nearer than we like to think.

Disclosure: No Positions